How to approach your pension to help with future success

Retirement can seem far away, and you’re probably thinking about more immediate money goals right now, like saving for a house or booking a holiday. But by taking some time to look at your savings and pension, you could make it pay off for you in the future.

Other than the state pension (Opens in new window), there are two different types of pension in the UK: one that's linked to how long you've been a member of the scheme and your final or average earnings, which is generally known as a final salary or defined benefit pension, and one that's linked to the amount of money in your pension fund, which is generally known as a money purchase or defined contribution pension.

Personal pensions and most employer pensions are now money purchase schemes. However, there are still some final salary pensions, especially for those in the public sector, such as teachers and those in the police force. This article looks at how money purchase schemes work.

The earlier you start putting money away, the more time you’ll have on your side to allow your pension pot to grow. This is because of the ways pensions are invested – but more on that later. That's easier said than done, however, when you’re juggling a budget, bills and the general cost of day-to-day living. So, what could you do to make a pension plan that’ll work for you?

Why it pays to plan for retirement

The truth is, we’re all living longer. This means if you stopped working at 70, you could have 20 or more years to pay for, which can seem overwhelming. Here are some pension facts to be aware of when it comes to your retirement:

• The most you can currently receive from the new UK State Pension is £203.85 a week. However, there are a couple of instances where this could be different (Opens in new window)
  
• If you're a permanent eligible employee, you’re automatically enrolled in your workplace pension scheme
  
• In order to receive a reasonable pension, at least 8% of your earnings should be paid into a workplace pension (Opens in new window) for which you're automatically enrolled. Your employer should pay at least 3%, with you making up the remainder. The amount you or your employer contributes may be higher than this, depending on the pension scheme rules
  
• If you’ve opted out of your workplace pension or you're self-employed and don’t have one, you might want to start your own personal pension

Benefits of a pension

The good thing about both workplace and personal pensions is that you can get tax relief on your contributions. That means some of the money you would have paid in tax on your earnings goes into your pension pot rather than to the government. In other words, you end up with more because you're not paying tax on the amount that goes into your pension. Better still, some employers also offer to pay more into your pension, known was 'contribution matching', if you make your own contributions. This helps accelerate the growth of your retirement benefits.

Tax relief on pension contributions is available on earned income for both employees and the self-employed. Pension contributions are also subject to the pension annual allowance (Opens in new window) limit of £60,000.

Don’t worry if you think your workplace pension won’t give you the income you need once you’ve retired. The good news is you might be able to add to it by increasing your pension contributions if you have any spare money. Again, the earlier you start the ball rolling, the more time your overall pot will have to grow.

If you're self-employed and a basic-rate taxpayer, it's worth paying into a personal pension because for every £100 you put in, it will be topped up by £25 income tax relief from the government. The income tax relief increases based on your income tax rate (Opens in new window).

For individual tax residents in England, Wales and Northern Ireland, the effective income tax rates are:

• Taxable income: £12,571 to £50,270 = Income tax rate: 20%
• Taxable income: £50,271 to £100,000 = Income tax rate: 40%
• Taxable income: £100,001 to £125,140 = Income tax rate: 60%*
• Taxable income: £125,141 and over = Income tax rate: 45%

* those earning more than £100,000 will see their Personal Allowance reduced by £1 for every £2 earned over £100,000, and you’ll also need to do a Self Assessment (Opens in new window) tax return.

Tax residents of Scotland are subject to different income tax rates (Opens in new window)

Make some time to manage your money

If you’re wondering where to find the extra money to pay into your pension, you’re not alone. Money can be tight for a lot of us these days. But, by taking a look at your finances and focusing on paying down any debts, you might be able to free up some cash to add to your pension.

The world of compounding returns

Reportedly, Albert Einstein described compounding interest as 'the eighth wonder of the world'. So, what is it? Compound interest is the idea of savings growing like a snowball rolling down a hill. The earlier you start to save, the greater the effects of compound interest. Compound interest can make a big difference to the value of your pension over time, because the interest that you earn is reinvested, and you earn interest on that.

Here's how compound interest works, let's explore an example scenario to see how it performs:

• If you saved £300 a month for 25 years and kept it under your mattress, you’d end up with £90,000. But if you invested this in a pension fund with an interest rate of 6% compounded annually, that amount would turn into £197,512 – giving you an extra £107,512
• If you started saving in this way at the age of 25, stopped contributing at 50 and retired at 65, you’d end up with £473,349 – because that lump sum of £197,512 would have kept on rolling down the hill, earning compound interest and being reinvested

(Please bear in mind that the 6% used here is an example number. It assumes a constant rate and does not consider potential changes in tax regulations, pension contribution rules or inflation.)

But what if you’d waited until you were 35 before starting these savings contributions? You’d be 72 by the time you reached the £473,349 amount. So, by prioritising your pension and starting earlier, it could really pay off in the long run, helping you to live comfortably during retirement and beyond.

Useful reading

• What is pension consolidation?
• Ways to save for retirement when your budget is tight
• Could you retire to a hotel – or a cruise ship?

Disclaimer: As with all investing, your capital is at risk. The value of your portfolio can go down as well as up, and you may get back less than you invest. Tax treatment depends on individual circumstances and may be subject to change in the future. A pension may not be right for everyone. If you are unsure if a pension is right for you, please seek financial advice. Tax treatment depends on your individual circumstances and may be subject to change in the future. We do not offer any tax advice.

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